Will the money market go into Crisis #3?

Financial Express, 5 November 2008

Crisis #1. The global financial crisis reached a new stage on 15 September with the death of Lehman Brothers. On this day, acute tightness hit the money market in Bombay and in London. This reflects the new world where India has become financially well integrated into the world economy. Indian companies who were habitually utilising the money market in London required dollars since the money market in London had dried up. In addition, Indian companies who were obtaining overseas trade financing switched to obtaining this locally. In order to meet these demands, a lot of Indian companies borrowed in rupees on the money market, and took this money out of the country.

The call rate flared up from 6% on 12th September to 14% a week later. Over these days, the money being taken from the RBI repo by the banking system jumped from Rs.12,000 crore to Rs.70,000 crore. These events were not, then, properly understood either by RBI or by the stock market. Nifty was unchanged between 12th and 19th September.

With tight money market conditions, companies who had outsourced their treasuries to mutual funds started pulling their money back, which set off a domino effect into various other problems. The banking system was chronically tight; it repeatedly crossed Rs.90,000 crore of money from the RBI repo from 29 September to 10 October. Through all this, the call money rate stayed in double digits. From 19 September to 10 October, Nifty lost a thousand points.

The correct policy responses to this involved infusing the system with rupee liquidity, with dollar liquidity and with moves to ensure and enable currency hedging. RBI responded from 15 October onwards. This was quite a pleasant surprise for the market. These moves were surprisingly rapid and surprisingly deep. RBI and the government, by and large, looked good for having correctly understood the problem and responded with a delay of only two weeks. The call rate dropped to 7% on 15 October.

But then, two things went wrong. First, in the Credit Policy announcement of 25 October, RBI struck a wrong note. The Credit Policy document should have been a crisp and well-written analytical treatment of the events from 12 September onwards, explaining RBI's moves and setting the intellectual framework for future action by RBI. Instead, the Credit Policy document seemed to be one year out of date, discussing issues like the need to rein in high credit growth. This was quite disconcerting for the market, which felt a loss of confidence in RBI's understanding and willingness to act.

The most important thing in a credit crunch is confidence, in the eyes of the market, that the money market will not choke up. If financial firms are confident that the money market will not choke up, they will feel confident in borrowing on the money market and lending out to various borrowers for various horizons. The credit policy document directly damaged credit access in the economy by reducing this confidence.

Crisis #2. More importantly, last week, money market tightness resurged. On 31st, the call rate was once again nudging 20%. The crisis on the money market was back, all over again. The market was confused. Just a few days earlier, RBI had understood that such a malfunctioning money market was unacceptable and had solved the problem. Why, then, did RBI write such a low quality credit policy document, and why did RBI permit the money market to choke up again?

Over the weekend, RBI has come out with a remarkable series of initiatives to solve the problems of rupee liquidity and dollar liquidity. These measures were urgently needed and have not come a day too soon. These measures will help end Crisis #2 on the money market.

While these measures are squarely on the right track, the deeper problem that must now be addressed is that of how monetary policy operates and how it is communicated.

The blow hot - blow cold behaviour of RBI has confused the market. The market is now mistrustful; it is worried that in a week or two, Crisis #3 will commence. With such mistrust, lending will not start. RBI needs to overhaul its operating procedures and its communication strategy in order to (a) ensure that the money market will not seize up again and (b) credibly communicate this to the market.

For this, the banking system must be flush with the bonds that can be pledged with RBI in exchange for cash, so that the call money rate will just not flare up. This requires making oil bonds and fertiliser bonds repo-eligible, and cutting the SLR to 20%. RBI must publicly announce that it will do whatever is required to ensure that riskless borrowing on the money market does not involve interest rates higher than the RBI repo rate.

A key source of confusion is currency trading of RBI. RBI's sale of dollars yields money market tightness. The market sees a number for reserves every week, but it does not know how much of the change in reserves was caused by valuation changes as opposed to RBI's trading. This uncertainty, which destabilises the stock market, the currency market and the money market, needs to be ended by releasing the currency composition of reserves, and RBI's trading activities, every week. On Friday evening, the market should know exactly what RBI did in the week that went by in terms of currency trading.

The RBI Governor must now do a speech laying out his analytical framework and policy framework. This speech must have analytical strength and clear english. He must explain his understanding of the events from 12 September onwards, and within this framework, show what his policy framework and operating procedures will be. Monetary policy need not pre-commit what will be done tomorrow, for the future is un-knowable. But it must pre-commit what it will do at future dates under a range of scenarios. This will give confidence to the market that RBI has correctly understood what is going on, and that it will block Crisis #3. Only when this confidence is established will the financial sector go out and lend, and end the credit crisis.

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